Campaniano superior-Maastrichtiano inferior?

Conclusion:

The quality of risk management is (strong, satisfactory, weak).

Policy

Conclusion:

The board (has, has not) established effective policies

relating to the bank’s derivatives activities.

Objective:

To evaluate the adequacy of derivatives policies relating to

price risk.

1. Evaluate the adequacy of price risk management policies and

procedures. Determine if they:

• Establish price risk limits.

• Require periodic review of price risk exposure.

• Describe the method used to calculate price risk exposure.

• Describe the acceptable process for market valuation.

• Require independent validation of price risk models.

• Require periodic stress testing.

• Require periodic back-testing of price risk models.

• Address reporting and control of off-market trades, if permitted.

• Require annual board approval.

• Require preparation and distribution of position reports by an independent party, without intervention by the trader or risk-taking unit.

• Require timely notification of actual or probable limit exceptions.

• Require prompt consideration of all limit exception requests (generally, approvals should be obtained from the next higher level of management).

• Address monitoring and tracking of limit breaks and exception approvals.

2. Determine whether management’s policy for review and

updating of assumptions underlying the pricing, revaluation, and risk measurement models is reasonable. Determine whether management complies with the policy.

Objective:

To evaluate the adequacy of derivatives policies relating to

liquidity risk.

1. Evaluate the adequacy of liquidity risk management policies

and procedures. Determine if they:

• Require the incorporation, if material, of derivatives and corresponding collateral, margin arrangements, and early termination agreements into liquidity-related management information systems and contingency plans.

• Detail circumstances in which the bank will honor noncontractual early termination requests.

• Describe when the bank will provide credit enhancements.

• Limit the amount of assets that can be encumbered by collateral and margin arrangements (such limits are generally determined after performing analyses to identify

requirements under adverse scenarios).

• Limit the amount of collateral tied to common triggers (e.g., credit rating).

• Require annual board approval.

2. Determine whether established limits adequately control the

range of liquidity risks. Determine that the limits are appropriate for the level of activity.

3. Evaluate the bank’s policies addressing the use of early

termination triggers. Determine if they:

• Discourage use of early termination triggers where the bank is subject to termination.

Comptroller’s Handbook 99 Risk Management of Financial Derivatives

• Allow early termination triggers only after careful

consideration of the impact on price risk exposure and bank liquidity.

• Clearly define the circumstances under which management will honor a request for early termination when it is not part of the customer’s contract.

Objective:

To evaluate the adequacy of derivatives policies relating to

foreign currency translation risk.

1. Evaluate the adequacy of foreign currency translation risk

management policies and procedures for derivatives activities. Determine if they:

• Discuss the objectives of the program to manage the level of capital exposed to foreign currency revaluations. Ensure these objectives are clearly articulated, measurable, and reasonable.

• Discuss issues regarding activities in countries possessing illiquid or nondeliverable currencies.

• Define exposure limits within which the bank seeks to operate.

• Discuss both branches and affiliates.

• Clearly identify the persons responsible for managing the level of capital exposed to foreign currency revaluations, and require that they be independent of other trading areas.

• Define whether exposure will be managed on a centralized or decentralized basis.

• Define requirements for limit exceptions and approvals.

• List appropriate products to be used to hedge exposure, and identify individuals responsible for monitoring hedge performance.

• Provide prudent safeguards against adverse currency fluctuations.

• Require annual approval by the board or appropriate committee.

Objective:

To evaluate the adequacy of derivatives policies relating to credit risk.

1. Evaluate the adequacy of credit risk management policies

and procedures. Determine if they:

• Establish guidelines for derivatives portfolio credit quality, concentrations, and tenors.

• Require at least annual counterparty review and assignment of risk ratings.

• Establish and define formal reporting requirements on counterparty credit exposure.

• Require designation of separate counterparty limits for presettlement and settlement credit risk.

• Require independent monitoring and reporting of aggregate credit exposure for each counterparty (including all credit exposure from other business lines) and comparison with limits.

• Describe the mechanism for policy and limit exception approvals and reporting, including situations where a counterparty credit line is exceeded because of a large market move (e.g., collateral calls, up-front payments, termination).

• Require an evaluation of the appropriateness of customer transactions.

• Address transactions with undisclosed counterparties.

• Address permissibility and reporting of off-market trades (including historical rate roll-overs).

• Address administration of nonperforming contracts. (This policy should be consistent with policies adopted in traditional lending divisions.)

• Address allowance allocations and require derivatives credit reserves to cover expected losses.

• Require annual board approval.

2. Evaluate the bank’s policies and written agreements regarding

Comptroller’s Handbook 101 Risk Management of Financial Derivatives

the use of credit enhancements. Determine if they:

• Require evaluating the counterparty’s ability to provide and meet collateral or margin requirements at inception and during the term of the agreement.

• Address acceptable types of instruments for collateral and margining.

• Address the ability to substitute assets.

• Address time of posting (i.e., at inception, upon change in risk rating, upon change in level of exposure).

• Establish valuation methods (i.e., sources of pricing, timing of revaluation).

• Address the ability to hypothecate contracts.

• Address physical control over assets.

• Address dispute resolution.

3. Evaluate bank policies covering customer appropriateness.

Determine if they:

• Clearly outline specific responsibilities for both credit and marketing officers.

• Clearly define the type of documentation, if any, to be maintained by both credit and marketing personnel.

• Define the types of disclosures or representations, if any, to be made to customers.

• Provide guidance to marketers on avoiding the implication of an advisory relationship.

• Provide a framework for evaluating counterparty sophistication and transaction complexity.

• Require an independent party periodically review

counterparty exposures to identify new and significant mark- to-market exposures.

• Require that significant adverse exposures are brought to senior management’s attention.

4. Determine whether the bank trades with investment advisors

or other third parties acting as agents on behalf of undisclosed counterparties. Determine if:

• The bank has developed a credit policy that addresses trades involving undisclosed counterparties.

• The credit policy limits exposure to undisclosed

counterparties and provides for periodic monitoring. Types of limits and controls could include:

– Requiring careful review and approval of the practice by

senior management and the board.

– Restricting transactions to agents and other

intermediaries to only those persons and firms known to be reputable and who agree to the bank’s risk

management requirements.

– Restricting transactions to an approved list of

counterparties.

– Limiting the size of transactions with undisclosed

counterparties individually and in aggregate.

– Limiting transactions to very liquid, spot FX or short-term

forward transactions involving high-quality securities with regular DVP settlement.

– Requiring third-party guarantees or collateral to ensure

performance.

• The bank has obtained legal opinions regarding the

enforceability of any written agreements.

• The bank has ensured compliance with the “know your customer” requirement of applicable money laundering regulations.

Objective:

To evaluate the adequacy of derivatives policies relating to

transaction risk.

1. Evaluate the adequacy of transaction risk management

policies and procedures for derivatives activities. Determine if they address:

• Segregation of duties between trading, processing, and payment functions.

Comptroller’s Handbook 103 Risk Management of Financial Derivatives

• Description of accounts.

• Trade entry and transaction documentation. • Confirmations.

• Settlement. • Exception reporting.

• Documentation tracking and reporting. • Revaluation.

• Reconciliations including frequency. • Discrepancies and disputed trades. • Broker accounts.

• Accounting treatment. • Management reporting.

2. Determine whether personnel policies require that key

employees take two weeks of consecutive vacation.

Objective:

To evaluate the adequacy of derivatives policies relating to

compliance risk.

1. Determine that policies require appropriate legal review of all

relevant activities including new products, counterparty or agreement forms, and netting arrangements.

2. Obtain a copy of the bank’s accounting procedures and

review for conformance with the relevant sections regarding trading and hedging transactions within authoritative

pronouncements by the Financial Accounting Standards Board and call report instructions.

3. In the absence of authoritative accounting guidance,

determine whether the bank’s accounting policy for

derivatives transactions is reasonable and consistently applied.

Objective

: To evaluate the adequacy of derivatives policies relating to

reputation risk.

1. Determine if the board established a code of ethics/conflict of

interest policy for trading activities that provides an adequate

framework to control risk to the bank’s reputation. Determine if the policy:

• Prohibits any deceptive, dishonest, or unfair practice.

• Provides for a mechanism to monitor gifts and gratuities.

• Prohibits false or materially misleading marketing material.

• Provides for the disclosures and consents necessary to avoid conflicts of interest.

• Provides for a system to determine the existence of possible control relationships.

• Prohibits the use of confidential, nonpublic information without the written approval of affected counterparties.

• Prohibits the improper use of funds held on another’s behalf.

• Designates specific principals to supervise personnel and business conduct in general.

• Adopts price mark-up guidelines.

• Allocates responsibility for transactions with the bank’s own employees and employees of other dealers.

2. If the bank uses derivatives in a fiduciary capacity, contact

the examiners reviewing “Fiduciary Activities” for their assessment of how derivatives are managed in a fiduciary capacity and the adequacy of related policies and

procedures.

Objective:

To evaluate the adequacy of derivatives policies relating to

strategic risk.

1. Determine if the board has established a new product policy.

Determine that the policy requires that all relevant areas, such as the business line, systems, risk control, credit, accounting, legal, operations, tax, and regulatory compliance, evaluate risks and controls. Determine if the policy:

• Defines a new product or activity.

Comptroller’s Handbook 105 Risk Management of Financial Derivatives

• Establishes a process to identify new product transactions. Determine if new product documentation is required to:

– Describe the product.

– Explain the product’s consistency with business strategies

and objectives.

– Identify and evaluate risks and describe how they will be

managed.

– Describe the limit and exception approval processes. – Describe capital allocations.

– Describe accounting procedures.

– Summarize operational procedures and controls. – Detail approval of legal documentation.

– Address other legal and regulatory issues. – Explain tax implications.

– Describe the ongoing maintenance process.

Processes

Conclusion:

Management and the board (have, have not)

implemented effective processes to manage derivatives activities.

Objective:

To determine the adequacy of processes relating to

management of price risk in derivatives activities.

1. Evaluate the manner in which trading strategies are

formulated, executed, and monitored. Consider the following:

• Line management’s day-to-day oversight of trading activities.

• The limits and restrictions on delegated authorities.

• Requirements for approving trading in new products, markets, and extended maturities.

• Management’s authority and willingness to modify or override trader decisions (using offsetting positions or specific instructions).

• Modifications in varying market conditions.

2. Obtain a list of recent price risk limit exceptions. Determine

whether the exceptions were identified and approved on a timely basis. Determine whether the basis and timeliness of approval were reasonable and within the approver’s authority. Evaluate the level and nature of the exceptions.

3. Determine that the types of pricing models used and their

capacities are appropriate for the nature and volume of business conducted. Determine the person(s) responsible for developing and maintaining the models.

4. Evaluate the method used to measure price risk exposure.

Determine who developed and maintains the system. Assess whether the method is commensurate with the nature and complexity of the activity conducted. Determine whether:

• Price risk is measured on a desk, country, regional, and global basis.

• The bank’s systems can aggregate price risk exposure across all products, desks, branches, and globally.

• The method considers the characteristics of the underlying instruments in view of the following:

– Tenor of the instrument.

– Changes in price under varying market conditions, in

response to changes in liquidity, etc.

– Estimated holding period or time to close or hedge the

position.

• The methodology expresses risk as a percentage of current

earnings or capital.

• The exposure arising from a change in applicable major market factors, such as interest rates, foreign exchange rates or market volatility, can be aggregated, evaluated, and reported in a timely manner.

• The system facilitates stress testing.

5. If the price risk measurement system does not include all

sources of price risk exposure, estimate the percentage of risk

Comptroller’s Handbook 107 Risk Management of Financial Derivatives

captured by the system. Determine whether senior

management is aware of coverage levels and if the omissions are reasonable in view of the circumstances.

6. Determine whether management performs adequate stress

testing. Evaluate:

• The basis for stress scenarios.

• The reasonableness of stress scenarios.

• Whether the frequency of stress testing is appropriate.

• Whether stress tests incorporate the interconnectedness of risks.

• Whether senior management and the board are apprised of the results of portfolio stress testing.

Objective:

To determine the adequacy of processes relating to

management of liquidity risk in derivatives activities.

1. Determine whether the bank maintains closeout cost reserves. If so, determine whether the method for calculating the

reserve is reasonable.

2. Determine that the bank’s liquidity risk management function

has a separate reporting line from traders and marketers. 3. Ascertain whether good communication exists between

derivatives managers and persons responsible for domestic and foreign currency funding.

4. Review the bank's contingency liquidity plan to ensure that it

includes derivatives. This step should be coordinated with the examiner assigned to review “Liquidity.” Determine if the plan:

• Addresses potential market liquidity and cash flow funding aberrations for both on- and off-balance-sheet instruments.

• Requires projections of cash flows (including asset usage from credit enhancements) under normal and stressed market conditions. Individual bank and system liquidity

crises should be projected.

• Assigns specific duties and responsibilities to individuals to manage derivatives in the event of deteriorating, as well as crisis, situations.

• Addresses the impact of collateral requirements and early termination requests.

Objective:

To determine the adequacy of processes relating to

management of foreign currency translation risk in derivatives activities.

1. Review the bank’s systems to determine the timeliness and

completeness of the information used to make cross-border investing and hedging decisions.

Objective:

To determine the adequacy of processes relating to

management of credit risk in derivatives activities.

1. Evaluate the process for determining whether a derivatives

transaction is appropriate for the counterparty. Select a sample of recent derivatives transactions. The sample should focus on nondealer counterparties and include:

• Contracts with large mark-to-market values (both positive and negative).

• Complex, leveraged, and plain vanilla transactions.

• Off-market, extended, or terminated transactions. 2. Review both the credit and marketing files for sample

transactions to assess the adequacy of documentation

relating to determining appropriateness. Discuss the sampled transaction with the responsible credit and/or marketing

officers. Determine if:

• Credit files contain sufficient information to

understand the risks the customer is attempting to manage,

Comptroller’s Handbook 109 Risk Management of Financial Derivatives

types of derivatives expected to be used, and the overall impact on the customer.

• Marketing files contain information on the transaction and any disclosures given to the customer (e.g., customer profile information, deal term sheets, sales presentations, scenario analysis, correspondence).

3. Evaluate the adequacy of the credit risk measurement method

used to calculate presettlement credit exposure through

review of model information and discussions with management. Determine if:

• The system produces a reasonable estimate of loan-

equivalent exposure including the current exposure (mark- to-market) plus an estimate of the potential change in value over the remaining life of the contract (add-on).

• The credit risk add-on calculation is:

– Statistically derived from market factors.

– Consistent with the probability modeling used to

evaluate price risk, except that the add-on calculation will use the remaining life of the contract as a time

horizon.

– Based on peak exposure.

• The frequency of credit calculations is adequate.

• The bank maintains documentation to support that the assumptions used in the credit risk exposure calculation are updated as appropriate.

4. Review the credit risk measurement method used to calculate

settlement exposure, and determine that it provides a reasonable estimate of risk.

5. Determine the degree to which the credit risk measurement

system can aggregate credit exposure, on both a gross and net basis, across desks, branches, and/or globally.

6. Determine the extent to which management uses settlement,

closeout, or multilateral netting arrangements. Determine:

• Whether the bank’s operational systems can accommodate netting.

• Whether counterparty payments or credit exposures are netted for purposes of computing periodic settlement or reporting aggregate credit exposures.

• The process whereby management ensures that a signed master agreement is on file before netting is performed. Evaluate the bank's system to track and resolve unsigned master agreements.

7. Select a sample of counterparties where credit exposure is

netted. Trace to supporting master agreements to ensure that each counterparty with which management nets exposure for risk management purposes has signed a master agreement. 8. Obtain a list of recent credit limit and policy exceptions.

Determine whether the exceptions were identified and approved. Determine whether the basis and timeliness of approval was reasonable and within the approver’s authority. Evaluate the level and nature of the exceptions.

9. Determine how the credit risk control function notifies traders of

deteriorating trends in a counterparty’s financial condition or changes in limits. Also determine how traders communicate their knowledge of counterparties’ deteriorating financial condition to the credit risk control function.

10. Determine whether there have been any recent counterparty

credit downgrades or deteriorations affecting the bank's trading activities. If so, determine the bank's response. 11. Determine how the bank identifies and reports past-due

counterparty payments. Review the bank’s past due, watch list, or deteriorating trend reports. Discuss management’s workout strategy for these counterparties.

Comptroller’s Handbook 111 Risk Management of Financial Derivatives

12. Determine whether the bank maintains credit reserves for

counterparty exposures apart from the allowance for loan losses. Determine whether the method for calculating the reserves is reasonable.

13. Determine whether appropriate bank personnel have

reviewed the counterparty’s agreement with the investment advisor to assess the type of activities that are authorized or prohibited.

14. Determine whether senior management and credit risk

management have assessed credit risk exposure arising from

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